October 19, 2008

Fair Game

We’ll Rescue You on Four Conditions

By GRETCHEN MORGENSON

YOU may have been wondering what it takes to get overpaid executives to rein in excessive compensation. Well, now you know. It takes a historic financial market conflagration and hundreds of billions of taxpayer dollars in bailouts.

It is only fitting, of course, that restrictions on executive pay be part of any deal in which beleaguered taxpayers rescue companies that helped drive the country into a ditch. Here’s a data point: The nine banks participating in the capital infusion program paid their former and current chief executives a total of $231 million last year.

So it is gratifying to see Henry M. Paulson Jr., the Treasury secretary, applying common sense to executive pay at institutions being propped up with investments from the Bank of You and Me.

There are four aspects to the compensation rules in the so-called Capital Purchase Program:

Part 1: Combating the kinds of incentives that encouraged outsized risk-taking by managers.

Part 2: Recovering compensation given to senior executives who benefit from reported earnings that turn out to be inaccurate, typically known as “clawback” provisions.

Part 3: Prohibiting golden parachutes — which the Internal Revenue Service defines as more than three times an executive’s average pay prior to retirement.

Part 4: Making companies pay taxes on any compensation an individual receives over $500,000. (Normally, compensation up to $1 million per executive is tax deductible.)

SO, is all of this good, bad or indifferent from the taxpayer’s standpoint? I asked Brian Foley, an independent compensation consultant in White Plains, to analyze the pay program as he would any public company’s plan.

Part 1, restricting pay incentives that encourage risk, is so basic, Mr. Foley said, that it should not even have to be specified. “It looks to me like the plan calls for a self-administered process where the company’s compensation committee will commit to get together periodically with its risk officers,” he said. “They should have been doing that all along. And if they weren’t, they should be doing it now anyway.”

When it comes to clawbacks, Treasury’s plan takes a slightly tougher stance than a similar requirement in the Sarbanes-Oxley law. For example, while Sarbanes-Oxley’s clawbacks relate only to chief executives and chief financial officers, Treasury’s provision covers the three most highly paid executives in addition to those two officers. In the future, the Treasury plan also doesn’t limit the time period to which the clawbacks can be applied.

Enforcing clawback provisions could not be more paramount. Consider the recent performance of the nine banks participating in the Treasury infusion plan. Between early 2004 and mid-2007, these banks earned a total of $305 billion. Since then, they have written down their assets to the tune of $323 billion.

“The notion that we have to take a harder look at clawbacks is overdue,” Mr. Foley said. “That involves not only having better provisions permitting the clawback, but if there is no provision companies should go for them anyway. Let the executives go in front of a jury and try to win that one.”

Mr. Foley added that the Treasury’s recovery provision won’t necessarily cover employees who earn more than the top five executives, like top-producing sales representatives or heads of highly profitable subsidiaries.

For instance, Treasury’s rule would not have applied to Joseph J. Cassano, the executive overseeing the unit at the American International Group that sent the insurance giant off the rails. Mr. Cassano earned $280 million over the last eight years, according to Congressional documents; his unit racked up $25 billion in losses.

As for the parachute limits, Mr. Foley called them barely limiting. If an executive earned $10 million annually in the previous five years, he or she would still be entitled to $29.9 million in exit pay. That ain’t nothin’.

Moreover, two executives earning the same amount and generating the same corporate performance could receive wildly different treatment under the Treasury plan. Say two executives both earn $10 million in total compensation annually. If one exercised stock options worth a total of $30 million in the prior three years, then his average annual pay would rise to $20 million, entitling him to a parachute of $59.9 million.

If the other executive had not exercised stock options, his exit package would be $29.9 million.

“This gets deep into the vagaries of parachute calculations,” Mr. Foley said. “It is a limit that will have uneven results.”

As for the $500,000 cap on deductible pay, Mr. Foley said it is interesting that the limit appears to apply to any executive, even after he or she retires, who was among the top five targets — even if only for one year. “Once you are part of the top five it appears that you are permanently targeted,” he said.

Optimists may hope that restrictions on pay at financial institutions dining on the public dime will force similar moves at other companies and boards. But Mr. Foley isn’t so sure.

Because compensation tied to stock prices is already falling, companies are less likely right now to restrict their pay plans, he said. “You almost have to batten down the hatches and take the best shot with the programs that are in place.”

AS for financial institutions, bonus pools will be savaged regardless of the Treasury’s new rules because, by any financial measure, those companies’ performance has been abysmal.

Gary Lutin, an investment banker at Lutin & Company, convened a shareholder forum on executive pay for investors and managers last July. With the taxpayer now on the hook for executive pay, the topic has only grown in significance.

“If we want to save our economy we need to establish a reward system that’s based on simple fairness,” he said. “Everyone understands fairness and at least most of us want it. But it is painfully obvious now that what we’ve been doing has not worked.”

A version of this article appeared in print on October 19, 2008, on page BU1 of the New York edition.